Does a Roth IRA Conversion Make Sense for You?

What is a Roth conversion?

A Roth conversion is done by converting or rolling over an existing Traditional IRA and/or tax qualified plan (like a 401(k), 403(b) or 457) into a Roth IRA.1

The income tax free withdrawals that Roth accounts offer make them an attractive investment option. However, the tax implications of a Roth conversion may be significant.

What are the advantages of a Roth conversion?

The primary advantage of a Roth IRA is that the asset growth, dividends and interest aren’t taxable while assets are held in the plan. In addition, when you withdraw assets from the Roth IRA, the distributions are income tax free under certain conditions.Roth conversions can offer these other advantages:

Lifetime minimum distribution rules don’t apply to Roth IRAs.2 With Roth IRAs, there is no required beginning date when you must begin distributions. 3

There is no maximum age for contributing to a Roth IRA.

There is tax diversity among your retirement accounts. If you have both a Traditional plan and a Roth plan, you can control how much cash flow comes from pretax and after-tax sources during your retirement. This flexibility can help you if you’re balancing between two tax brackets.

Roth conversions are generally risk free in the short term. This is because you typically have until April 15th or October 15th of the year after you convert to switch back or “recharacterize” to a Traditional IRA.4

What should you consider before converting?

1. Roth conversions are taxableThe pretax amount you convert is included in your gross income in the year of the conversion. For tax purposes, the IRS treats all IRAs as a single IRA, even when the IRA consists of deductible and nondeductible contributions. Therefore, there is no advantage in converting the IRA with the greatest nondeductible contributions. The reverse is true however, with 401(k) or 403(b) plans. These plans are not aggregated, so it is possible to convert the plan that holds the most after-tax contributions.

2. Paying taxes on the conversionThe IRS treats a conversion from a Traditional plan to a Roth plan as a distribution. That means that the conversion amount is included in your gross income and is taxable — just like an actual distribution of the same amount from your Traditional plan would be taxable. You’ll pay tax on the converted amount at your applicable tax rate.

If you’re younger than 59½, you’ll likely incur a 10% penalty on any portion of the converted plan that you use to pay the income tax liability and/or on any portion of the plan withdrawn for other reasons after the conversion. Therefore, if you’re younger than 59½, it’s generally suggested that you do a conversion only if you have adequate nonqualified (after-tax) assets available to pay the income tax liability. There are exceptions to this penalty tax if you are disabled or buying a first home.5

If you’re older than 59½, you can pay the tax from the converted assets without penalty. Make sure you carefully review your strategy because the tax payment from the Roth reduces the plan’s size, resulting in fewer assets available to grow tax deferred in the Roth plan. Furthermore, you must be willing to abide by the five-year period.

3. Income tax ratesIf you expect to be in a lower income tax bracket in the future, it might be more beneficial to keep your assets in the Traditional plan for now. But if you expect to be in a higher income tax bracket in the future, there may be a greater benefit to converting.

4. Investment performancePay attention to the financial markets. You don’t want to pay federal and state tax now on the conversion of a Traditional plan only to see the converted account’s value decrease later.

5. Beneficiary considerationsIf your individual beneficiary (or a trust you established for the beneficiary) is in a higher income tax bracket than you, a conversion might make sense. Especially if you don’t need to draw from the plan during your life and can pay the income tax liability from other assets. Also, if you wish to leave a plan to a noncitizen spouse or to a trust for a special needs child, a conversion might be a good strategy because it removes income tax considerations from the equation.

6. Distribution rulesIf you might need access to the converted funds in the short term, make sure you know the rules governing Roth distributions. To make a qualified distribution, you need to meet the following requirements:

You must be at least 59½ years old or qualify for one of the exceptions to receive a qualified distribution.6

You can’t take a distribution from a Roth plan for at least five years after the conversion. Under this five-year period rule, you must generally wait at least five years from the first day of the tax year in which you made the conversion before you can take a qualified distribution.

Get help with your decision

It’s important that you work with a qualified attorney or tax advisor to develop a fundamental understanding of the Roth conversion strategy and how it may apply to your specific circumstances.

1 Distributions from tax-qualified retirement plans — including 401(k) plans, tax-sheltered annuities (section 403(b) plans), and governmental 457 plans — are candidates for conversion. You can also convert a Simple IRA, but only after you participate in the Simple IRA plan for at least two years.

2 Roth 401(k)/403(b) plans are subject to the same lifetime minimum distribution rules as their Traditional counterparts.

3 Distributions from a Roth IRA cannot be used to fulfill a minimum distribution requirement arising from a Traditional retirement plan account.

4 If you do a Roth conversion and decide you are unhappy about it, or if you discover that you were not eligible to convert, you can “recharacterize” the conversion. This recharacterization must be made on a “trustee-to-trustee” basis instead of by rollover, the original contribution and net income must be transferred back, and irrevocable notice must be given to the plan trustee. Please note that you cannot recharacterize an “in-plan” conversion (a conversion of non-Roth funds to Roth funds within the same qualified plan). If you do recharacterize, you generally cannot do a reconversion until the latter of: 1) the taxable year following the taxable year of the original conversion, or 2) 30 days after the switch back.

5 Since you already paid the appropriate tax on the original conversion amount for the calendar year in which you converted the asset, the tax and penalty amount is generally imposed upon the earnings rather than upon the original conversion amount.

6 There is an exception for a disability, your death, or if you qualify as a first-time home buyer.

The tax information herein is not intended to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.

Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.

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1 Distributions from tax-qualified retirement plans — including 401(k) plans, tax-sheltered annuities (section 403(b) plans), and governmental 457 plans — are candidates for conversion. You can also convert a Simple IRA, but only after you participate in the Simple IRA plan for at least two years.

2 Roth 401(k)/403(b) plans are subject to the same lifetime minimum distribution rules as their Traditional counterparts.

3 Distributions from a Roth IRA cannot be used to fulfill a minimum distribution requirement arising from a Traditional retirement plan account.

4 If you do a Roth conversion and decide you are unhappy about it, or if you discover that you were not eligible to convert, you can “recharacterize” the conversion. This recharacterization must be made on a “trustee-to-trustee” basis instead of by rollover, the original contribution and net income must be transferred back, and irrevocable notice must be given to the plan trustee. Please note that you cannot recharacterize an “in-plan” conversion (a conversion of non-Roth funds to Roth funds within the same qualified plan). If you do recharacterize, you generally cannot do a reconversion until the latter of: 1) the taxable year following the taxable year of the original conversion, or 2) 30 days after the switch back.

5 Since you already paid the appropriate tax on the original conversion amount for the calendar year in which you converted the asset, the tax and penalty amount is generally imposed upon the earnings rather than upon the original conversion amount.

6 There is an exception for a disability, your death, or if you qualify as a first-time home buyer.

The tax information herein is not intended to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties. Taxpayers should seek advice based on their own particular circumstances from an independent tax advisor.

Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.